Currency overlay programmes are predominantly used by US investors, but J P Morgan finds more Europeans are receptive to the concept

An investment approach which has grown in popularity over the last decade in the US is currency overlay. Currency overlay is defined as a mandate with no direct control on underlying international assets, where a manager is hired purely to focus on currency decisions. Although it is predominantly a US investment style, more and more European investors are considering their positions on this critical issue.

For years, academics and professionals have debated the effects of currency exposure on international portfolios. While this dispute may continue for some time, our research points to the conclusion that currencies are an independent source of risk. Left unmanaged, currency exposure increases portfolio volatility and impacts short-term performance.

Without realising it, most international investors make currency decisions every day. Every time money managers buy foreign securities, they have to buy the currencies required to settle the transactions. Therefore, a fund which does not explicitly address currency exposure may unwittingly be adopting a strategy that weights foreign currencies in equal proportion to foreign securities.

Currency exposure should be decided by your risk and reward preferences (with respect to currency), not by the stocks or bonds your asset manager picks.

How currencies affect your portfolio

Over the very long term, the effect of currency returns on a portfolio is expected to be small. However, short-term movements (generating both positive and negative returns) are far from nil. For example, UK investors saw large foreign currency gains in 1992 when sterling left the ERM. Then in 1996 and 1997, those gains turned into equally significant losses.

Local currency movements are not at all correlated with local equity market returns. Currency rates and the resulting investment returns are driven by a completely different set of fundamentals than those driving equity markets. Currency is a medium of exchange - not an asset. Its value is derived from the relative demands for domestic and foreign goods and assets.

An opportunity for active managers to add value

Our own research and track record show that structured and disciplined active currency management can add value over the long-term, with low levels of residual risk. For instance, during 1994 and early 1995, the US dollar had declined against all major currencies. At the same time, the yen was rising. Objective fundamental signals indicated the dollar was undervalued. Those with conviction would have added to their US dollar position while it was cheap. By December 1995, the US dollar had, in fact, strengthened against the yen - enough so that following a disciplined investment approach generated significant excess return.

Create the need to manage residual risk

For most international equity managers, country allocation equals currency allocation. When asset managers underweight Japan, for instance, they also make the implicit decision of under- weighting Japanese yen. Chart 1 shows the range of residual risk, on a currency-by-currency basis, caused by the implicit currency allocations from almost 50 to 150 basis points. The median residual risk for the WM Non-US Universe was 1.5% at December 31, 1995. The median, though it may seem low, actually masks the broad range of unmanaged, arbitrary currency positions of each portfolio.

The residual risk resulting from the implied currency weights of a manager's country decision is an addition of residual risk with unclear compensating benefits. The residual risk caused by a currency overlay manager are a specialist's deliberate positions, based on researched decisions about the currency markets.

We believe that investors with no view on currency markets should, at least, cross hedge back to their benchmarks to eliminate unnecessary residual risk.

The benefits of bringing in the currency specialist

Your goal is to hire the best equity managers to pick your stocks and the best fixed income managers to select your bonds. It follows that you should also employ the best currency managers to manage separately your currency exposure. A currency specialist's mandate is to analyse currency fundamentals, assess value and risks in the currency markets and reflect this speciality in an international portfolio. This creates a range of benefits:

* Higher potential returns with controlled risk - Currency specialists concentrate exclusively on analysing and managing currency exposure and seek to add extra return to international portfolios.

* Lower transactions costs - Dedicated currency traders seek the most cost-effective trades using a diversified range of counterparties.

* Custom reporting on currencies - Performance, credit risk, and a host of other tailored reports measure the effect of currency exposure on international portfolios.

* Reduced cash flow-related costs - To implement currency decisions, specialist currency managers integrate their cash flow management with the overall cash of the fund. Asset managers tend to sell international assets to fund currency hedging activities.

* Improved credit risk management - Currency specialists manage credit risk by diversifying transactions among a carefully screened group of foreign exchange counterparties.

Chart 2 summarises the different styles of strategic currency benchmark. A currency specialist can help you choose which strategic benchmark is right for you, as no two investors are the same.

Styles of currency management

Active currency managers have different styles. Some are fundamental, some are technical, some actively manage volatility and some are combinations. Passive currency managers continuously maintain the currency weights of your benchmark, regardless of country allocation. By hiring currency specialists with different approaches, your portfolio should be further enhanced through diversification of residual risk.

Conclusion and recommendations

Whatever your base currency, we encourage you to evaluate how currency exposure is currently affecting your international portfolio. Consider the risk and return benefits of separating currency from your country allocation decision. Currencies add a distinct source of volatility to your international portfolio. Prove to yourself that an active currency specialist may not only reduce volatility, but help transform it into excess return.

If you would like to find out more, please contact Harriett Richmond, Adrian Lee or Lydia Read at JP Morgan Investment Management on +44 171 451 8000

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